China: Stagnation in the Catching Up Process?

Chinese political authorities are concerned about their country which is feared to face a “middle-income trap”. The definition of such a trap is not clear but it could be understood as stagnation in the process of catching up to the rich countries and a significant decline in growth of per capita income.

To be more precise, what the Chinese authorities fear has not yet materialized. China is still a lower middle-income country following World Bank definition. The way to a high-income country passes via the upper middle-income country stage which China is expected to reach within the next few years. And it is there where in the past the majority of upper middle-income countries got trapped and failed to achieve the high-income status which starts at a level of about 12,200 US-$. Economic historians mark the 10,000 US $ per capita income level (PPP) as a junction from where economic growth tends to decline.

To discuss the reasons of such decline, it is beyond doubt, that in China, the average productivity of physical investment, often measured by its reciprocal, the incremental capital-output ratio ICOR, has declined. In 2009, the Chinese ICOR has been found to be twice as high as its average in the 1980s and 1990s. That, by itself, must not necessarily mean a waste of capital if high physical investment coincides with slow growth in the world economy because of a global crisis and if ICORs rise globally.  But as Chinese fixed-asset investment has increasingly gone into infrastructure, such investment, especially in remote regions, will not immediately pay off. Hence, the price to paid by China for possible (or likely) future returns of massive investment in infrastructure in a vast and geographically dispersed country, is that today much more physical capital is needed to achieve a specific level of growth than in the past.

Furthermore, other bottlenecks which were already identified as barriers against sustained double-digit growth rates some twenty years ago appear more binding than at that time. The quality and quantity of labor supply which is needed to match the rise in per capita- income in terms of skill content is no longer as elastic as it used to be. Physical bottlenecks such as energy availability and the use of the environment as a sink have become serious and the rise of income inequality to a Gini coefficient of close to 0.5 ( historically high for  a non-resource-rich economy in general and for China in particular) puts the normally high degree of social coherence and stability at risk. Disparities are present at any level, between coastal provinces and the Western and Central provinces, between rural and urban areas, and between the property and income positions of those working in profitable export industries and those confined to activities for the domestic market. Social security schemes lack sufficient coverage and discriminate against or even exclude thus those who are in most need of support (for instance, rural workers).

Finally, financial repression hampers an allocation of domestic funds to efficient investment. Such repression comprises barriers against investment abroad of domestic savings, upper caps on deposit rates for private savers, biases in domestic lending against private households and in favor of the corporate sector, in particular in favor of SOEs, and credit controls instead of the free play of interest rates. As a result, bond and equity markets are still in a state of infancy. Each of these bottlenecks can individually prevent China from fully exploiting its growth potential. Taken together, doubtlessly, they will slow down economic growth.

It seems, however, that the general question of China approaching a middle-income trap or not, is misplaced. The real issue is whether beyond the big cities or agglomerations like Beijing/Tianjin, Shanghai and Guangshou/Pearl River Delta which are already close to or within the high-income status, the rest of the country will be trapped. For the time being, China is separated in a number of “economies”. This is not a new phenomenon. Some twenty years ago, the ratio between income measured at PPP rates and income at current exchange rates, was measured between six in remote areas in the West and close to unity in the coastal cities.

The size of the difference is determined by the prices for non-tradables and the size of the non-tradable sector relative to the tradable sector. While in the coastal cities prices for non-tradables such as consumer services were close to international prices, they were far from international prices in the remote areas. In spite of sizable cross-country labor mobility through migrant workers, labor markets in China are still far from being integrated.

Large skill differentials play a role but also policy-rooted restrictions, such as the internal registration scheme (Hukou) which ties people to their traditional place of residence and forces migrant workers to live in an environment of illegality cut off from public services which normal citizens enjoy.   The Hukou system fragments Chinese labor markets and is responsible for some part of persistent income disparities over regions and people.  Nevertheless, the catching up process of backward areas is under way, no doubt. Growth rates in low-income provinces exceed those of higher-income provinces but if endowment differentials are taken into account, the catching up process must be expected to take much more time.

In other words, the superior endowment of higher-income provinces with technology, infrastructure, and skills protects these provinces against fiercer locational competition with lower income areas. While the latter provinces can still embark upon the catching up model of high investment ratios, the former provinces must raise their total factor productivity through innovations to better use of the existing capital stock. Actually, they do it. With labor supply getting tighter in the high-income provinces and with the low-income provinces impeded in their growth path by a relatively high share of employment in the agricultural sector, labor-saving investment in this sector will be important to release labor for other activities and for productivity improvement in the low-income provinces. Again, a reform of the Hukou scheme would be helpful.

As a result, the issue of a middle-income trap for China seems to be a problem of how fast lower-income provinces achieve the status of high income provinces. Estimates by Richard Herd from the OECD suggest that by 2020 13 instead of only 3 provinces (in 2015) will arrive at the high-income level and that it will be no earlier than 2030 that almost all of the 33 provinces will have followed. By that time, China will already be in the stage of becoming an aging economy. To defend the status of a high-income country after having achieved it, will then probably be a tougher task than to initially reach it..

(Slightly revised version of an article published on February, 6, 2012, on Linnaeus University’s blog China Research under the title “China Ahead of a “Middle-Income Trap?”.)